Modern Economy, 2013, 4, 818-820

Published Online December 2013 (http://www.scirp.org/journal/me)

http://dx.doi.org/10.4236/me.2013.412087

Discounted Cash Flow Model 2.0

Patrice Gélinas
School of Administrative Studies, Faculty of Liberal Arts & Professional
Studies, York University, Toronto, Canada
Email: gelinas@yorku.ca

Received October 28, 2013; revised November 25, 2013; accepted December 2, 2013

Copyright © 2013 Patrice Gélinas. This is an open access article distributed under the Creative Commons Attribution License, which
permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. In accordance of
the Creative Commons Attribution License all Copyrights © 2013 are reserved for SCIRP and the owner of the intellectual property
Patrice Gélinas. All Copyright © 2013 are guarded by low and by SCIRP as a guardian.

ABSTRACT
Unexpected takeover premiums could be due to the limitations of traditional discounted cash flow models that do not
take into account the synergetic potential of the valued assets, which should be acquired by another firm. The author
offers a method to value a firm taking into account potential value sitting outside the firm due to synergetic potential.
The magnitude of this value depends on the scale of potential synergies, on the willingness of third parties to acquire the
firm and the post-acquisition use of the assets.

Keywords: Financial Analysis; Asset Valuation Theory; Mathematical Finance; Synergies; Net Present Value;
Probabilistic Model

1. Introduction cause it ignores the possibility that the net assets being
analyzed may have the potential to generate greater fu-
Investors are regularly surprised by the takeover premi-
ture cash flows if merged into the operations of another
ums that acquirers offer to gain control over the net as-
firm. Indeed, potential synergies are often the main ar-
sets of a target firm. Takeover premiums are puzzling to
guments that acquirers put forth to justify takeovers to
interpret using efficient market arguments. They also
their own shareholders.
suggest that financial analysts rely on flawed or incom-
We consequently suggest revisiting the traditional
plete valuation assumptions while using one of the sev-
DCF valuation model in a 2.0 version that includes the
eral variations of the traditional discounted cash flow
synergetic potential of the assets being analyzed when
(DCF) valuation model1:
estimating future cash flow streams. Synergies can come
CFt  i from two main sources. As stated before, the first is the
Value   (1)
1  r  potential for greater projected net future cash flows when
i
i
assets are merged into an acquirer’s pre-acquisition as-
In the equation, r corresponds to the risk-adjusted re- sets. The second source of synergies stems from the po-
quired rate of return and i indicates the number of years tential ability to use a lower discount rate to calculate the
until cash flows (CF) will be earned or released after present value of future cash flows if a merger makes the
valuation time t. Dividends, accounting earnings and assets less risky i.e., less likely to become obsolete.
“free cash flows” are three widely used alternative CF
measures that analysts select depending on whether they 2. Certainty of Acquisition
wish to value the firm’s equity or the firm’s debt plus When assets or operations are integrated in those of the
equity2. acquiring entity to produce cash flows, it is possible that
An implicit assumption of the traditional DCF model they subsequently become impossible to resell to another
is that the assets will be used optimally by the firm being potential acquirer. In that case, if it is certain that poten-
valued. This assumption can lead to undervaluation be- tial acquirers will acquire the target firm when it is prof-
1
For a review, see [1] Fernandez (2007). itable for them to do so, then the DCF Model 2.0 value of
2
For example, see chapter 19 in [2] White et al. (2003). the firm is:

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 CFtki  corresponds to the case of Equation (5) where all prob-

Value 2.0  max   i 
(2) abilities are equal to 1.
 i 1  rk  
k
Estimating future cash flows that a set of assets could
In the equation, k indicates the stand-alone firm being produce should they be merged with the assets of another
valued as well as each of its potential acquirers. For po- firm is akin to the work performed by financial analysts
tential acquirers, CF indicates net incremental cash flows supporting managers whose investment strategy is to
which are discounted at a rate r consistent with the po- assemble portfolios of firms they perceived as plausible
tential acquirer’s business conditions. candidates for “at premium” takeovers. The market inef-
ficiencies these investors exploit would likely shrink with
In a case where the stand-alone firm being valued
the adoption of the DCF Model 2.0 by financial analysts.
could be sold to a third party or spun off after being ac-
quired, the DCF Model 2.0 value of the firm is:
4. Illustration
 CFk 
Value 2.0   max  t i
i 
(3) Table 1 presents an illustration where a firm’s assets will
i
k
 1  rk   generate cash flows for four years only whether it oper-
ates on a stand-alone basis or merged with any of three
This latter case is analogous to a situation where the potential acquirers A, B and C. For further simplicity,
assets of the firm can be operated by current owners or assume that cash flows are paid at yearend, that cash
leased by the owners of a possibly different acquirer flows are presented net of integration costs and of canni-
during each future time period. balistic effects on acquirers’ projected cash flows, that
potential acquisitions would have no effect on the present
3. Uncertain Acquisition value of debt, that the r presented for acquirers are opti-
When it is uncertain that potential acquirers will take mal on a post-merger pro forma basis, that assets have no
over the target firm even if it were profitable for them to residual value, and finally that assets cannot be sold back
so and when the acquired firm would be impossible to and forth between potential acquirers nor spun-off once
resell following a post-acquisition integration, the DCF acquired.
Model 2.0 expected value of the firm is: In this illustration, the traditional DCF valuation
model (Equation (1)) would suggest a fair value of
Value 2.0
$65.61 for the stand-alone firm. Under certainty of ac-
  quisition, Equation (2) suggests a Value2.0 2
of $87.56,
CFtki CFttgt
 max  P[ Atk ] 
 1  P[ Atk ]  i  which would justify a takeover premium of up to 33.5%
 i 1  rk  1  rtgt  
k i i

i
over a market price based on the traditional valuation. In
(4) this illustration, both Firm A and Firm B would be ra-
tional acquirers.
In the equation, P[A] indicates the probability at valua-
If assets could be sold back and forth between poten-
tion time t that the target firm (tgt) being valued will be
tial acquirers or spun off once acquired, Equation (3)
acquired by potential acquirer k if it is profitable to do so.
would produce a firm Value2.0 3
of $105.95 as the assets
Equation (2) corresponds to the case of Equation (4)
are merged with those of Firm A in year 1, then Firm B
where all probabilities are equal to 1.
in year 2, Firm C in year 3 and back to Firm B in year 4.
In a case where the stand-alone firm being valued
If we assign a probability of acquisition (conditional
could be sold to a third party or spun off after being ac-
upon the acquisition being expectedly profitable) in all
quired, the DCF Model 2.0 expected value of the firm is:
periods equal to 70% for Firm A, 80% for Firm B, and
Value 2.0 90% for Firm C, Equation (4) yields an expected
 Value2.0 of $83.17 and Equation (5) an expected
CFttgti 
4
CFtki
  max  P[ Atki ]  1 P[ A k
]  Value2.0
5
of $99.41. With probabilities lowered to 50%,
1  rtgt  
t i
k  (1  rk )i i

i
60% and 70%, expected values would be lower at $78.78
(5) and $91.35, respectively.
In the equation, probabilities of acquisition (condi-
tional upon acquisition being expectedly profitable) must 5. Implications
be determined for each future period and, for simplicity, In addition to raising awareness about the importance of
they are assumed to be independently distributed. It is the synergetic potential of a firm’s assets, DCF Model
also assumed for simplicity that the costs of a spin off or 2.0 provides a framework to assess and quantify two
a sale to a third party acquirer are the same. Equation (3) valuation principles that may have been intuitively ap-

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Table 1. Illustrative example.

Stand-Alone Firm Merger with Firm A Merger with Firm B Merger with Firm C

Net CF1 $50 $50 $40 $50

Net CF2 $50 $50 $60 $55

Net CF3 $50 $50 $60 $85

Net CF4 $50 $50 $80 $40

Market Value of Debt $100 $100 $100 $100

r 8% 6% 8% 15%

Present Value of Net Future CF $65.61 $73.26 $87.56 $63.83

Premium vs. Traditional Model --- 11.7% 33.5% −2.7%

pealing. First, a firm that remains marketable after it has REFERENCES

been acquired has a value greater than, or equal to, a [1] P. Fernandez, “Valuing Companies by Cash Flow Dis-
similar firm whose operations must be integrated perma- counting: Ten Methods and Nine Theories,” Managerial
nently and “destructively” into the operations of its ac- Finance, Vol. 33, No. 11, 2007, pp. 853-876.
quirer to deploy synergies (i.e., Value（5） 2.0
 Value（4）
2.0
). http://dx.doi.org/10.1108/03074350710823827
Second, a firm that is more likely to be acquired has a [2] G. I. White, A. C. Sondhi and D. Fried, “The Analysis
value greater than, or equal to, a similar firm less likely and Use of Financial Statements,” 3rd Edition, 2003,
to be acquired because both Value2.0 4
.0 and Value2.0 5
.0 Wiley, New York.
are monotonically non-decreasing as P[A] increases.
DCF Model 2.0 consequently implies that a compre-
hensive analysis of a firm’s competitive environment,
especially its potential fit as a potential target for acquisi-
tion, may lead to more accurate valuations and less sur-
prising acquisition premiums.

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